Unit 3
RATIO ANALYSIS
Once the financial statements of an organization are prepared, they then need to be analysed. One such tool
to analyse and asses the financial situation of a firm is Ratio Analysis. It allows the stakeholder to make
better sense of the accounts and better understand the current fiscal scenario of an entity. Let us take an in-
detail look at ratio analysis.
Meaning of Ratio Analysis
Ratio analysis is a process of determining and presenting the relationships of items and group of items in
the statements. An accounting ratio can be defined as quantitative relationship between two or more
items of the financial statements connected with each other. Arithmetically ratio is a comparison of the
numerator with the denominator.One of the most important financial tools, which has come to be used
very frequently for analysing the financial strengths and weaknesses of an enterprise, is ratio analysis.
A ratio expresses simply in one number the result of a comparison between two figures. When the
relationship between two figures of the balance sheet is established, the ratio so calculated is called
balance sheet ratio.
The ratio of current assets to current liabilities is the example of balance sheet ratio. If relationship
between the figures of profit and loss account is established, the result so found is regarded as income
statement ratio. Ratio of gross profit to sales is the example of income statement ratio.When the
relationship of figures in income statement and balance sheet is established, e.g., the ratio of net profit to
total capital employed, the ratio is known as inter-statement ratio.
Objectives of Ratio Analysis
Interpreting the financial statements and other financial data is essential for all stakeholders of an entity.
Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Some objectives
of ratio analysis are as follows:
1. Measure of Profitability: Profit is the ultimate aim of every organization. Context is required to
measure profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense
ratio etc provide a measure of the profitability of a firm. The management can use such ratios to find out
problem areas and improve upon them.
2. Evaluation of Operational Efficiency: Certain ratios highlight the degree of efficiency of a company
in the management of its assets and other resources. It is important that assets and financial resources be
allocated and used efficiently to avoid unnecessary expenses. Turnover Ratios and Efficiency Ratios will
point out any mismanagement of assets.
3. Ensure Suitable Liquidity: Every firm has to ensure that some of its assets are liquid, in case it
requires cash immediately. So, the liquidity of a firm is measured by ratios such as Current ratio and
Quick Ratio. These help a firm maintain the required level of short-term solvency.
4. Overall Financial Strength: There are some ratios that help determine the firm’s long-term solvency.
They help determine if there is a strain on the assets of a firm or if the firm is over-leveraged. The
management will need to quickly rectify the situation to avoid liquidation in the future. Examples of
such ratios are Debt-Equity Ratio, Leverage ratios etc.
5. Comparison: The organizations’ ratios must be compared to the industry standards to get a better
understanding of its financial health and fiscal position. The management can take corrective action if
the standards of the market are not met by the company. The ratios can also be compared to the previous
years’ ratios to see the progress of the company. This is known as trend analysis.
Advantages of Ratio Analysis:
The information shown in financial statements does not signify anything individually because the facts
shown are inter-related. Hence it is necessary to establish relationships between various items to reveal
significant details and throw light on all notable financial and operational aspects. Ratio analysis caters
to the needs of various parties interested in financial statements. The basic objective of ratio analysis is
to help management in interpretation of financial statements to enable it to perform the managerial
functions efficiently.
,The following are the advantages of ratio analysis:
(1) Forecasting:Ratios reveal the trends in costs, sales, profits and other inter-related facts, which will
be helpful in forecasting future events.
(2) Managerial Control:Ratios can be used as ‘instrument of control’ regarding sales, costs and profit.
(3) Facilitates Communication:Ratios facilitate the communication function of management as ratios
convey the information relating to the present and future; quickly, forcefully and clearly.
(4) Measuring Efficiency:Ratios help to know operational efficiency by comparison of present ratios
with those of the past working and also with those of other firms in the industry.
(5) Facilitating Investment Decisions:Ratios are helpful in computing return on investment. This helps
the management in exercising effective decisions regarding profitable avenues of investment.
(6) Useful in Measuring Financial Solvency:The financial statements disclose the assets and liabilities
in a format. But they do not convey relationship of various assets and liabilities with each other, whereas
ratios indicate the liquidity position of the company and the proportion of borrowed funds to total
resources which reveal the short term and long-term solvency position of a firm.
(7) Inter Firm Comparisons:The technique of inter-firm comparisons can be carried out successfully
only with the help of ratio analysis. Otherwise, no firm may come forward to disclose full information.
Inter-firm comparisons help the management to compare its performance with an external ‘benchmark’
or standard.
Classification of Ratios
Ratios are classified in several ways. Different approaches are used for classifying ratios. There is no
uniformity in classification by different experts. They have adopted different stand points for classifying
ratios into various groups.Some of the classifications are as follows:
CLASSIFICATION OF RATIO
, Liquidity/ Short Long-term Solvency Profitability Ratios Activity Ratios/Sales
Term Solvency Ratios/Leverage/Capital Ratios
Ratios Structure Ratios
Gross Profit Ratio Stock Turnover
Current Ratio Debt-Equity Ratio Net Profit Ratio Ratio
Liquid Ratios/ Acid Proprietary Ratio Operating Ratio Debtors Turnover
Test Ratio/ Quick Solvency Ratio Operating Profit Ratio Ratio
Ratio Interest Coverage Expenses Ratio Creditors Turnover
Absolute Liquid Ratio/Debt-Service Return on Investment/ Ratio
Ratio Ratio Capital Employed Working Capital
Capital Gearing Ratio Earnings Per Share Turnover Ratio
Dividend Per Share Investment
Dividend Yield Ratio Turnover Ratio
A. LIQUIDITY/SOLVENCY RATIOS
Solvency is the ability of firm to meet its liabilities at the due date. It has two dimensions: Short-term
solvency; and Long-term solvency.
Short-term solvency reflects the short-term financial strength of the firm i.e., liquidity. Liquidity is basic
to continuous operations of firm. The object of liquidity analysis is to examine the firm’s ability to meet
its current obligations out of short-term resources. This analysis provides help in examining the
efficiency and effectiveness of the management in utilizing the working capital of the business.
Liquidity Ratios: The ratios which indicate the liquidity of a firm are known as “liquidity ratios”. The
following ratios are calculated to assess the liquidity of a firm:
Current Ratio
Liquid Ratio
Absolute Liquidity Ratio
a) Current Ratio: This ratio provides the picture of the ability of a company to pay back its short-
term liabilities with its short-term assets. The higher current ratio explains that the company has
the high potential to pay its obligations. A ratio of 2:1 is considered as the fair ratio. The
current ratio below 1 indicates that the company is not able to pay back its due obligations.
Current ratio below 1 shows the poor financial health of the company. This is calculated as
follows:
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬
Current Ratio= 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
Here, Current Assets include: Stock, Debtors, Cash, Bank A/c, Bills Receivables, Short-term
investments, pre-paid expenses, Work-in-progress, Finished Stock, Accrued Income, etc.
Current Liabilities include: Creditors, Bills Payable, Bank Overdraft, Short-term Debts/ loans,
Provision for taxation, Reserve for Bad debts, Income tax in advance, outstanding expenses,
unaccrued income, etc.
b) Liquid Ratio: Liquid ratio is also called quick or acid test ratio. The main concept behind this
ratio is that sometimes it is difficult to sell or use the stocks which creates problem. This ratio
RATIO ANALYSIS
Once the financial statements of an organization are prepared, they then need to be analysed. One such tool
to analyse and asses the financial situation of a firm is Ratio Analysis. It allows the stakeholder to make
better sense of the accounts and better understand the current fiscal scenario of an entity. Let us take an in-
detail look at ratio analysis.
Meaning of Ratio Analysis
Ratio analysis is a process of determining and presenting the relationships of items and group of items in
the statements. An accounting ratio can be defined as quantitative relationship between two or more
items of the financial statements connected with each other. Arithmetically ratio is a comparison of the
numerator with the denominator.One of the most important financial tools, which has come to be used
very frequently for analysing the financial strengths and weaknesses of an enterprise, is ratio analysis.
A ratio expresses simply in one number the result of a comparison between two figures. When the
relationship between two figures of the balance sheet is established, the ratio so calculated is called
balance sheet ratio.
The ratio of current assets to current liabilities is the example of balance sheet ratio. If relationship
between the figures of profit and loss account is established, the result so found is regarded as income
statement ratio. Ratio of gross profit to sales is the example of income statement ratio.When the
relationship of figures in income statement and balance sheet is established, e.g., the ratio of net profit to
total capital employed, the ratio is known as inter-statement ratio.
Objectives of Ratio Analysis
Interpreting the financial statements and other financial data is essential for all stakeholders of an entity.
Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Some objectives
of ratio analysis are as follows:
1. Measure of Profitability: Profit is the ultimate aim of every organization. Context is required to
measure profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense
ratio etc provide a measure of the profitability of a firm. The management can use such ratios to find out
problem areas and improve upon them.
2. Evaluation of Operational Efficiency: Certain ratios highlight the degree of efficiency of a company
in the management of its assets and other resources. It is important that assets and financial resources be
allocated and used efficiently to avoid unnecessary expenses. Turnover Ratios and Efficiency Ratios will
point out any mismanagement of assets.
3. Ensure Suitable Liquidity: Every firm has to ensure that some of its assets are liquid, in case it
requires cash immediately. So, the liquidity of a firm is measured by ratios such as Current ratio and
Quick Ratio. These help a firm maintain the required level of short-term solvency.
4. Overall Financial Strength: There are some ratios that help determine the firm’s long-term solvency.
They help determine if there is a strain on the assets of a firm or if the firm is over-leveraged. The
management will need to quickly rectify the situation to avoid liquidation in the future. Examples of
such ratios are Debt-Equity Ratio, Leverage ratios etc.
5. Comparison: The organizations’ ratios must be compared to the industry standards to get a better
understanding of its financial health and fiscal position. The management can take corrective action if
the standards of the market are not met by the company. The ratios can also be compared to the previous
years’ ratios to see the progress of the company. This is known as trend analysis.
Advantages of Ratio Analysis:
The information shown in financial statements does not signify anything individually because the facts
shown are inter-related. Hence it is necessary to establish relationships between various items to reveal
significant details and throw light on all notable financial and operational aspects. Ratio analysis caters
to the needs of various parties interested in financial statements. The basic objective of ratio analysis is
to help management in interpretation of financial statements to enable it to perform the managerial
functions efficiently.
,The following are the advantages of ratio analysis:
(1) Forecasting:Ratios reveal the trends in costs, sales, profits and other inter-related facts, which will
be helpful in forecasting future events.
(2) Managerial Control:Ratios can be used as ‘instrument of control’ regarding sales, costs and profit.
(3) Facilitates Communication:Ratios facilitate the communication function of management as ratios
convey the information relating to the present and future; quickly, forcefully and clearly.
(4) Measuring Efficiency:Ratios help to know operational efficiency by comparison of present ratios
with those of the past working and also with those of other firms in the industry.
(5) Facilitating Investment Decisions:Ratios are helpful in computing return on investment. This helps
the management in exercising effective decisions regarding profitable avenues of investment.
(6) Useful in Measuring Financial Solvency:The financial statements disclose the assets and liabilities
in a format. But they do not convey relationship of various assets and liabilities with each other, whereas
ratios indicate the liquidity position of the company and the proportion of borrowed funds to total
resources which reveal the short term and long-term solvency position of a firm.
(7) Inter Firm Comparisons:The technique of inter-firm comparisons can be carried out successfully
only with the help of ratio analysis. Otherwise, no firm may come forward to disclose full information.
Inter-firm comparisons help the management to compare its performance with an external ‘benchmark’
or standard.
Classification of Ratios
Ratios are classified in several ways. Different approaches are used for classifying ratios. There is no
uniformity in classification by different experts. They have adopted different stand points for classifying
ratios into various groups.Some of the classifications are as follows:
CLASSIFICATION OF RATIO
, Liquidity/ Short Long-term Solvency Profitability Ratios Activity Ratios/Sales
Term Solvency Ratios/Leverage/Capital Ratios
Ratios Structure Ratios
Gross Profit Ratio Stock Turnover
Current Ratio Debt-Equity Ratio Net Profit Ratio Ratio
Liquid Ratios/ Acid Proprietary Ratio Operating Ratio Debtors Turnover
Test Ratio/ Quick Solvency Ratio Operating Profit Ratio Ratio
Ratio Interest Coverage Expenses Ratio Creditors Turnover
Absolute Liquid Ratio/Debt-Service Return on Investment/ Ratio
Ratio Ratio Capital Employed Working Capital
Capital Gearing Ratio Earnings Per Share Turnover Ratio
Dividend Per Share Investment
Dividend Yield Ratio Turnover Ratio
A. LIQUIDITY/SOLVENCY RATIOS
Solvency is the ability of firm to meet its liabilities at the due date. It has two dimensions: Short-term
solvency; and Long-term solvency.
Short-term solvency reflects the short-term financial strength of the firm i.e., liquidity. Liquidity is basic
to continuous operations of firm. The object of liquidity analysis is to examine the firm’s ability to meet
its current obligations out of short-term resources. This analysis provides help in examining the
efficiency and effectiveness of the management in utilizing the working capital of the business.
Liquidity Ratios: The ratios which indicate the liquidity of a firm are known as “liquidity ratios”. The
following ratios are calculated to assess the liquidity of a firm:
Current Ratio
Liquid Ratio
Absolute Liquidity Ratio
a) Current Ratio: This ratio provides the picture of the ability of a company to pay back its short-
term liabilities with its short-term assets. The higher current ratio explains that the company has
the high potential to pay its obligations. A ratio of 2:1 is considered as the fair ratio. The
current ratio below 1 indicates that the company is not able to pay back its due obligations.
Current ratio below 1 shows the poor financial health of the company. This is calculated as
follows:
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬
Current Ratio= 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
Here, Current Assets include: Stock, Debtors, Cash, Bank A/c, Bills Receivables, Short-term
investments, pre-paid expenses, Work-in-progress, Finished Stock, Accrued Income, etc.
Current Liabilities include: Creditors, Bills Payable, Bank Overdraft, Short-term Debts/ loans,
Provision for taxation, Reserve for Bad debts, Income tax in advance, outstanding expenses,
unaccrued income, etc.
b) Liquid Ratio: Liquid ratio is also called quick or acid test ratio. The main concept behind this
ratio is that sometimes it is difficult to sell or use the stocks which creates problem. This ratio
